Oil Reserves and Backwardation

I summarize my thinking about the Strategic Petroleum Reserve in an essay.

I am not persuaded that the "convenience yield" of the SPR justifies its costs. However, even if it does, I believe it makes sense to have a rule that ties the amount of oil we hold in the SPR to the pattern of oil futures prices. In particular, we should keep less in the SPR when there is backwardation, and fill the SPR when oil futures prices show a pattern of expected increase. Filling the SPR during a period of backwardation, as we are doing now, serves to worsen what the market sees as a temporary price spike.

In contrast to governments, rational speculators buy low and sell high. This process stabilizes markets. Irrational speculators, who buy high and sell low, destabilize markets. That is the effect of the Strategic Petroleum Reserve -- as Karl Kraus once said of psychoanalysis, the SPR is the disease that it purports to cure.

the former oil man suggested an interesting scenario. Should the future price of oil drop below the spot price (they are nearly equal now), it would make sense to hold back purchases and lower the oil cost by using futures. He called this an oil hedge. Traders call this backwardization [sic]. It's a rare president who understands this level of detail.

Apparently, the President is thinking about backwardation, also. But I am not sure why he believes that spot and futures prices are close, unless he is looking only at short-term futures prices. Long-term futures prices are clearly below spot prices.

For Discussion. If there were no Strategic Petroleum Reserve, would private sector incentives be sufficient to provide enough oil storage in case of a disruption in supplies?

Blogging time is restricted for a couple of days, but Arnold Kling's TCS piece on the Strategic Petroleum Reserve is quite good, as is his blog's follow up piece. Arnold sums up his theory regarding the SPR as follows: It... [Tracked on May 25, 2004 6:32 AM]

Are you aware that when Clinton released some oil from the SPR in 2000, it was actually a swap? Firms were allowed to take some oil from the SPR under the proviso that they replace it within some time period. At that time, forward prices were below spot prices, so those who were lucky enough to get one of the swap deals made instant arbitrage profits: "borrowing" oil from the SPR, selling at the spot price, and buying futures at the same time. Voila! Instant, locked-in risk-free profit.

Another often overlooked point: if we are operating at our refining capacity in the US, releasing extra crude will not help. To process it into gasoline, it would have to be shipped offshore, refined, and then brought back to the US. A process that would likely take about a month.

Arnold, I read the Tech Central Station article. For the most part I follow your argument and agree with it. One comment: it would seem that one of the goals of the SPR is to hedge against a situation where the oil market breaks down to a greater or lesser degree, i.e. a war that disrupts Altantic shipping, a nuclear exchange in the mid-East, etc. Don't you suspect that this is the SPR's "service yield" in the eyes of government planners?

Thankfully, it's hard to imagine such scenarios becoming reality, but does this change your analysis of the value of the SPR? What is an oil future worth if the market can't actually deliver your oil in a year?

The Strategic Petroleum Reserves are all located near the Gulf of Mexico; mostly in Louisiana, with a small amount in Texas. The operating sites are Bayou Choctaw, LA; West Hackberry, LA; Big Hill, TX and Bryan Mound, TX.

The capacity of the reserve is about 700M barrels and it currently has about 660M (according to the above site). This would lead one to believe that US Gov't oil purchases cannot be a major factor in the oil markets much longer (if they even are now).

What is important is not market failure in terms of pricing but the destruction of the market. An example I cited before; suppose an irrational Islamist group takes control of Saudi Arabia and some other Gulf states. They announce that they will not pump any oil for anyone! Choosing instead to live off of their cash reserves rather than earning oil dollars. They also announce any attempt to force the wells open by outside military action will result in the fields being blown up.

In one shot the world economy could be held hostage to such an irrational actor. Sure, eventually the high oil prices will cause innovators to finally replace oil...but we know what Keynes told us about the long run...

Are you aware that when Clinton released some oil from the SPR in 2000, it was actually a swap? Firms were allowed to take some oil from the SPR under the proviso that they replace it within some time period. At that time, forward prices were below spot prices, so those who were lucky enough to get one of the swap deals made instant arbitrage profits: "borrowing" oil from the SPR, selling at the spot price, and buying futures at the same time. Voila! Instant, locked-in risk-free profit.

But a nice way to lower a temporary spike in oil prices nonetheless. It's too bad the President doesn't have the authority to simply sell the oil in such situtation and automatically use the cash to purchase contracts for forward delivery. From the SPR's point of view they would 'profit' nicely in that they could end up with more oil then they started with.

Boonton writes:"suppose an irrational Islamist group takes control of Saudi Arabia and some other Gulf states. They announce that they will not pump any oil for anyone! Choosing instead to live off of their cash reserves rather than earning oil dollars."

Part of the reason why this scenario is implausible is the fact that there are basically no cash reserves in Saudi Arabia. They're running huge deficits. The Royals have all their cash safely stashed in Swiss banks and London property, if the House of saud was overthrown, their money would not accrue to the fundamentalists.

Regardless of what the fundamentalists might say, they're human and they want money. And their only source is oil. Iran has no problem selling oil, and neither would a radical government in Saudi.

With no Government Strategic Reserve, private sector would surely step in and regulate future supplies. In pre-history, oil companies were known to have taken over producing countries, formed trade associations ("cartels"), have influenced government to create strategic reserves at public expense and even have positioned their own people in high posts. Not now, of course!

Regardless of what the fundamentalists might say, they're human and they want money. And their only source is oil. Iran has no problem selling oil, and neither would a radical government in Saudi.

You are very shortsighted to underestimate the ability of humans to act against their own interests. If an Islamist takeover of Saudi Arabia sounds implausible to you how about a massive terrorist attack? It wouldn't be hard to imagine some group deciding that oil money has corrupted 'God's Kingdom' and taking action by blowing up major oil fields and pipelines. If done on the right scale, a major producer like Saudi Arabia could be incapaciated for a year or even more.

No Reserve can be of magnitude sufficient to save the Economy from extremely adverse terrorism. It will do even less as a Price suppressent. Oil should be allowed to join the Free Market, and let the $4.50 per gallon Gas negate excessive American consumption practices for Oil. lgl

If we had a truly free market in oil, it would cost about $8/barrel, and gasoline would be about 80 cents/gallon.

And people consume oil, not countries. What business is it of you or I how other people choose how to spend their money? If somebody want to spend $100 a week on gasoline, far be from me to tell them otherwise.

Barry,
You ignore the market in all its fine reminent. Eight dollar/barrel and $.80/gallon would quadtruple foreign consumption, while all Fields are producing at ninety percent maximum. The great debacle of the current Oil shortage is the fact China is expanding its consumption of Oil at much greater rate than Recovery expansion is capable. A per person estimate could suggest the Chinese have expanded their consumption on average by a triple dose. lgl

While China's energy demand fluctuates with its economic cycles, its overall trend is strongly up. I believe that China's oil consumption would double to 14 million barrels per day by 2014 from 7 million this year, unless China changes its energy policy dramatically. The problem with this forecast is that China couldn't afford the resulting high oil price. Considering the limited spare capacity in Saudi Arabia, oil price could exceed $80/bbl in ten years. China would have to spend $300 billion to import crude and related products per annum by then. It would be a huge drag on the Chinese economy.

China has to either become much more energy-efficient or find substitutes for oil. Nuclear energy, for example, could be a viable alternative. But, it takes 10 years to build a nuclear power industry. China has to act soon if it wants to adopt the nuclear option. The alternative is to limit the growth of the automobile industry. The current growth trend could triple China's fleet size to 100 million by 2014. Unless China changes the current trend, it would be too late to slow oil demand.

Robert Baer, an intelligence expert, [...] in his disturbing recent book, “Sleeping with the Devil” [...] reckons that Ras Tanura, a port on the Gulf, is a vulnerable terrorist target. With an output of perhaps 4.5m bpd, this is the biggest oil-exporting port in the world. Mr Baer thinks a small submarine or a boat laden with explosives (as happened in October 2000 with the attack on the USS Cole off the coast of Yemen) could knock out much of Ras Tanura's output for weeks, or even longer.

An even scarier possibility raised by Mr Baer is the crashing of a hijacked aeroplane into Abqaiq, the world's largest oil-processing complex. If done with the help of insiders, he speculates that the facility's throughput (nearly 7m bpd, on his estimate) would be choked off to as little as 1m bpd for two months—and might remain as low as 3m bpd for seven months.

Mr Woolsey adds that an attack using weapons of mass destruction (especially “dirty bombs”) would be even more devastating than one that used mere aeroplanes. All told, the pessimists reckon that well-co-ordinated attacks could take as much as 6m-7m bpd of Saudi output off the market for weeks, and perhaps longer.

Furthermore:

As chart 2 reveals, strategic petroleum stocks (which are stored in such places as salt domes in Louisiana) cannot be drawn down all at once. If a loss of Saudi output is anything like as long-lived as Mr Baer fears, or if other Middle Eastern output is also lost at the same time, then strategic stocks may prove inadequate. Prices will soar, and the market will return to equilibrium only through painful cuts in consumption and accompanying losses in economic output and welfare.

This isn't a real argument against the SPR. The SPR may work just fine to counter a 1-2 month interruption in oil shipments. No, the SPR won't save us if terrorists find a way to irradiate all of Saudi Arabia's oil.

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